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March 10, 2009

Before the Fall

By Peter Chapman

ITS Access
The ITS was terrific for Bernie," said Don Weeden, former CEO of Weeden & Co. "They were able to get their markets in and change them very quickly. They were very competitive with the New York and the other regional exchanges. He did very well doing that." (Weeden and Madoff are often considered in the same light, as both men took on the New York Stock Exchange in David-and-Goliath fashion and both invested heavily in technology to do so.)

While it never succeeded in becoming the central marketplace backers like Weeden and the SEC had hoped, the Cincinnati did retain a special standing in the eyes of the SEC.

One former Cincinnati specialist recalled that the rules of the exchange permitted maximum quote widths of 25 cents in the early 1990s, and so that was how he programmed his system. That got him a call from Peter Madoff, who asked the specialist to narrow his spreads. Madoff said the Cincinnati was always under scrutiny from the SEC and was held to a high standard. Tighter spreads would prove to the industry that the Cincinnati was "real" and its quotes accessible, Madoff explained.

Bernie would later tell Traders Magazine: "The Cincinnati has done a better job than the other regionals in keeping their market makers in a competitive mode. We set the standard at the Cincinnati."

The Customers
Now that Madoff had the ability to trade listed stocks, he set about the task of acquiring a steady stream of order flow from retail brokers. He won Charles Schwab & Co.'s business in short order, but the majority of brokers proved a tough slog. The business didn't really pick up until after the 1987 stock market crash.

During much of the 1980s, one source believes, the mainstay of Bernie's business was arbitraging the prices of OTC stocks with those of their attached warrants. Because the Black-Scholes options pricing model had yet to be fully understood by the Street, making money on the "optionality" of warrants was easy pickings. In those days, many speculative issuers, such as technology companies, would tack on a warrant to a new issue as a sweetener for the investor. The warrant was exchangeable into a certain number of shares at a certain price.

"The third market was almost a side business," this former trader said. "Bernie was very big in that [warrants] business, along with about four other firms. You could see. You would offer size, and Bernie would step up and buy it. Then he would be out there doing a contra trade in the common."

This source believes that the warrant trading operation was done under the aegis of Madoff's investment management operation, which allegedly eventually became a Ponzi scheme; and that losses in this warrant trading activity may have led to Madoff covering losses via the Ponzi scheme. "He had more share than you would expect a firm his size to have in those warrants," the source said.